What happens when a bank’s ability to meet demand for cash takes a hit – and how does that impact the other banks it’s connected to?

Bank liquidity regulations typically focus on an individual bank’s ability to quickly convert assets into cash, or its liquidity position, said Lina Lu, a senior financial economist at the Federal Reserve Bank of Boston.

A new working paper she coauthored that was published by the Bank’s Supervisory Research and Analysis group explores how a “shock” to one bank’s liquidity can ripple across a network of firms – especially in times of crisis, such as the COVID-19 pandemic.

“In this analysis, we see that it’s critical to take into account how one bank’s liquidity risks can spill over and impact other banks’ liquidity risks in the future,” Lu said. “Otherwise, we may be underestimating how much a shock is affecting an entire network of banks, and that could potentially compromise the stability of the financial system.”

What happens when a bank experiences a liquidity “shock?”

The paper is called, “Scenario-based Quantile Connectedness of the U.S. Interbank Liquidity Risk Network.” Lu’s coauthors are Tomohiro Ando, a professor of management at the Melbourne Business School, Jushan Bai, an economics professor at Columbia University, and Cindy Vojtech, chief of the Financial Institution Risk Evaluation Section at the Federal Reserve Board of Governors.

The researchers study how a liquidity shock to one bank impacted the liquidity positions of other banks before and during the COVID-19 pandemic. They find that this shock transmission, or “spillover,” was stronger during the COVID-19 period than the pre-pandemic period, on average. They also find that, on average, connections that can transmit risks between banks were stronger during the pandemic.

To explain why this happens, Lu said to consider the example of a bank that needs to increase its liquidity position after an unexpected shortfall. To do so, the bank might have to compete for deposits, sell investments, or take other actions. All these options can potentially impact other banks, she said.

Researchers study behavior of globally important banks in a crisis

To gain a view of a bank’s behavior in a crisis and potential spillover impacts to other banks, the researchers studied 12 domestic and foreign banks designated as “global systemically important banks.” These banks are required to report information about their liquidity position each business day.

The authors gathered data from before and during the pandemic about each bank’s “liquidity coverage ratio.” That’s the ratio of high-quality liquid assets, such as U.S. Treasury securities, over the bank’s estimated 30-day net cash outflows, and it represents a bank’s ability to use high-quality liquid assets to meet the demand for cash over the short term in times of stress.

The authors then developed a model to analyze how the effects of liquidity shocks spread through these institutions. That model measures liquidity risk, or “the possible distribution of liquidity in the future,” Lu said. That enabled the researchers to study how shocks to one bank’s liquidity position today can affect another bank’s liquidity risk in the future.

Lu said the researchers focused primarily on “idiosyncratic shocks,” or a type of shock that directly hits one bank, then studied how it spills over to other institutions in the network. They also studied the strength of the connections between the banks in this network before and during the pandemic.

“If there is a strong connection between two banks, then any shocks affecting one bank today can have a large effect on the other’s liquidity risk in the future,” Lu said.

Researchers: Banks more vulnerable to spillover shocks during crisis

The result was their finding that a shock to one bank’s liquidity position had stronger spillover effects across its network during the pandemic, compared to the pre-pandemic period.

“Overall, the level of bank vulnerability to other banks’ liquidity shocks is higher during the pandemic than pre-pandemic,” the researchers write.

The researchers say that analyzing liquidity risks between banks can help regulators identify which banks in a network are particularly vulnerable or systemically important, and this information can be useful for financial stability monitoring.

“Most studies in this area look at liquidity risk under normal conditions, but it is also important to examine liquidity risks during periods of severe stress,” Lu said. “Networks can act very differently during a crisis period, so we should take that into account."

Read the working paper on bostonfed.org.